Overview:  Innospec is a deeply undervalued, quality specialty chemicals company with minimal capex requirements trading for 3.6x LTM EBITDA and 4.0x EBITDA - capex.  At first glance, it looks like the sort of chronically cheap company that trades cheaply for good reason - legacy legal issues, one segment in terminal decline, one-time legal expenses, stagnant growth, substantial CEO turnover, seeming competitors who are over-earning (NEU & LZ), a past of crooked management, and recent negative headlines stirred by a prominent UK paper's "investigative report".  Look deeper, and we think you'll find a misunderstood company with a strong current management team, one bad declining business (Octane Additives, less than 15% of EBIT) that explains what went wrong in the past, misunderstood legal issues, and one high quality, growing business (Fuel Specialties, 77% of EBIT) that is more representative of the future.  As the bad business runs off over the next couple years, and the good business continues to perform well, we think the stock could more than double and, at current prices, should generate a 15% after-tax FCF yield on our 2011 estimates while you wait.

History - Why Innospec is cheap?

Innospec is cheap due to a variety of legacy issues in their Octane Additives business, most of which have been resolved and are now easy to quantify.  These issues stem from a crooked management team that is no longer with the company, and has been replaced with a high quality management team that was responsible for the strong growth of the fuel specialties business. 

Octane Additives consists entirely of TEL, which is a leaded fuel additive that raises the octane level of gasoline.  TEL was used extensively throughout the world until the 70s, when most developed countries began banning the additive due to the harmful environmental and health effects of lead.  The product is still used in many developing countries with poor infrastructure, where TEL is often the cheapest option for raising octane levels substantially, and one of the few viable options given the poor state of refinery infrastructure (countries include Afganistan, Iraq, North Korea, Yemen, etc.).  Much of the low valuation of IOSP from 2005-2007 was due to the fact that the company's largest, most profitable business was in terminal decline:

Just as IOSP's growing Fuel Specialties division started to shift investors' focus in 2007-2008, the company revealed that it was being investigated by the SEC & DoJ for bribery, kickbacks, and other charges under the oil for food program, most of which related to actions occurring between 2001-2005, two CEO's ago (as well as a couple of incidents in early 2007).  The charges would eventually expand to include wrongdoings in Indonesia & Cuba, and resulted in the resignation of the CEO in early 2009 (primarily for the smaller issues occurring post 2005).  All charges were confined to the Octane Additives business.  Upon resignation of the last CEO (Paul Jennings), Patrick Williams took control of the company.  Patrick grew up in the Fuel Specialties business, running the entire division since 2005 (growing topline 60% and tripling EBIT over the period). He also took control of the Active Chemicals division in 2008, and was largely responsible for much of the improvement in that business in 2009.  Simultaneously, Patrick took the team that had made the Fuel Specialties business prosper and has since promoted people from that division to head the other divisions of the company.

Everyone involved in the illegal wrongdoings in the TEL business  is no longer with the company, and the company has worked quickly to settle the lawsuit with the regulatory agencies.  In March of this year, Innospec settled with three regulatory agencies (DoJ, SEC, and the SFO in the UK) for $40.4M, to be paid out over the next 5 years.  We hired an experienced FCPA lawyer to review the court documents - our lawyer confirmed what the company has said, which is that this settlement settles all outstanding issues (see paragraph 14 of):

http://www.justice.gov/criminal/fraud/fcpa/cases/docs/innospec-plea.pdf

As part of the settlement, the company will hire a monitor to watch against future infractions.  According to our legal counsel, the only way the company would incur future legal penalties is if further wrongdoing occurs (unlikely, given change in management and increasing irrelevance of the business), or if the monitor or someone else were to uncover further past wrongdoings not uncovered in the initial two year investigation.  Of the 78 cases like this one, our legal counsel was only aware of one case in which further wrongdoing was found.  While it is possible that undiscovered illegalities occurred under past management, we believe odds are good that these would have been uncovered in the thorough previous investigation.

Despite the case being settled, news related to the settlement continues to leak out and create confusion about the status of the settlement:

http://www.fcpablog.com/blog/2010/6/28/naamans-guilty-plea.html  (June 28^th, Innospec's agent pleads guilty to bribery charges)

The stock took a further hit when The Guardian recycled the old news (all previously disclosed in various legal documents) and packaged it as a piece of fresh investigative journalism:

http://www.guardian.co.uk/business/2010/jun/30/octel-petrol-iraq-lead

It is possible that these negative headlines continue for some time as more former Innospec executives are charged criminally, but this should have no impact on the operating business or consequences in terms of future legal expenses going forward.  All this news creates an opportunity to by IOSP at a drastic discount to comps:

What will change to cause a revaluation?

With the legal issues now settled, and the TEL business a much smaller part of IOSP's business going forward, we believe the company's continued strong performance within their Fuel Specialties business (and potential upside from a continued turnaround in the Active Chemicals business) should result in a gradual revaluation of the business more in line with peers:

Fuel Specialties Financials:

Innospec's Fuel specialties business sells a variety of additives primarily used in diesel fuel (65% of business), and to a degree in gasoline, jet fuel, offroad fuel, and other fuel applications.  Innospec's diesel additives consist of refinery additives and performance additives.  Refinery additives, which include cetane improvers, cold-flow improvers, and lubricity improvers, are chemicals that add beneficial performance properties to diesel that allow the fuel to perform better.  Cold-flow improvers make diesel perform better in cold-weather (without these, the fuel may congeal causing the engine to fail to run in cold weather), and lubricity improvers help reduce engine corrosion (and are increasingly necessary with mandated lower sulfur content in fuel).  These additives are primarily added either at the refinery or in the terminal, and are required in most developed countries to some degree for regulatory reasons.  Performance additives include a variety of detergents and other additives that are used in branded fuel, primarily in Europe and other countries with high diesel penetration in consumer vehicles.  Examples of performance additives packages on the gasoline side, include Shell Vpower & Chevron with Techron, both of which are popular in the US.  Performance additives are often claimed to increase fuel efficiency, reduce engine corrosion, reduce emissions, or add other positive characteristics to the fuel that can differentiate it from competitors. Additive packages usually cost a fraction of a penny and allow large oil companies to slightly differentiate themselves from competitors.    Diesel consumption has grown historically at a 2-3% CAGR and should continue on that pace, with most growth coming from emerging markets.  Additives have outgrown diesel historically due to new regulatory requirements and more recently due to the gradual additization of fuel in developing countries consuming large amounts of diesel (Brazil, China, India, etc.).  The industry is very stable - customers typically enter into 3-5 year contracts, and customer switching (especially among large oil companies) is relatively rare (we spoke with multiple customers & competitors who confirmed this).  Within the diesel market, Afton Chemicals (a division of Newmarket) is Innospec's primary competitor.  Lubrizol competes in diesel detergents, and Infineum in diesel refinery additives.  Part of the reason for the undervaluation has also been some concern about gross margin pressure, especially given the unusually high margins achieved recently by Lubrizol and New Market in their lubricant additives business (diesel additives is tiny for Lubrizol and only several percent of New Market's business, but because they also compete with Innospec some people view them as comps).  The fuel additives market operates differently, however - margins have been much more stable historically, in part because 50% of Innospec's contracts contain price escalators - which we have confirmed with the company, competitors, and customers. Although we model gross margins ticking down slightly to 33%, this margin decline is not nearly as big as the potential decline that could occur at NEU or LZ. 

The company is also very excited about their active Chemicals business, which grew 22% last quarter ex-currency, and appears to be in the midst of a turnaround.  The company thinks they can get to 22-26% gross margins in this business, though we are currently modeling single digit growth and 19% gross margins to be conservative.

Pension:

A more recent issue is the company's pension liability.  The pension went from $10M underfunded to $134M underfunded in 2009, half of which was due to an actuarial forecast change of longer life-spans in the UK, and half of which was due to a lower assumed discount rate.  The company has since closed the pension, and is substantially raising pension expense to close the funding gap.  With currency shifts since the liability was reported, we believe the number today is closer to $125M, which has been accounted for in our valuation.

Valuation:

Innospec's financials are very messy, due to many of the one-time items discussed above.  Given our conservative assumptions for the two healthy businesses (Fuel Specalities & Active Chemicals), combined with the declining TEL business, higher pension expense, and a slight downtick in Fuel Specialties gross margin, we are modeling EBITDA declining from about 90M LTM to 71M by 2011.  But, because of the substantial cash flow generation from the business, we still arrive at an EV/EBITDA of 3.6x by 2011.  Or, looked at another way, the stock still trades for 4.1x our 2011 EBITDA number which assumes a slight downtick in EBITDA due to the factors mentioned above.  We think ultimately that pension expense will decline beyond 2011, and that there is substantial upside to our operating assumptions given the company's guidance and execution history under the current CEO.

We arrive at a conservative price target of $19 (70% upside) using a 5.8x EV/EBITDA multiple, assuming low single digit growth for Fuel Specialties (and 33% margins), high single digit growth for Active Chemicals, and zero EBIT generated by the Octane Additives business in 2011.  Nearly the entire value of the company is derived from the two healthy segments by 2011.  Using more optimistic assumptions more in line with management guidance (mid/high single digit growth for Fuel Specialties, low teens for Active Chemicals as well as 24% gross margins, and a 7x EBITDA multiple we arrive at a price target of $26 a share (130% upside).  We treat the pension expense (16M in 2011) as an ongoing operating expense and subtract it from the operating business EBITDA when calculating our valuation, which we view as conservative since part of the pension expense is effectively debt paydown.  We prefer to subtract the pension expense rather than treat the underfunded amount as debt, since the liability is a moving target, whereas the pension expense for the next 2 years is a known quantity.  We also treat the $40.4M settlement liability as debt.

Key Risks:

1)      Further legal issues - while we view this as unlikely this is possible.

2)      Customer defection - the company has several large customers in its fuel specialties business, including Shell which is about 13% of their revenue.  Portions of contracts with these companies often come up for renewal every 3-5 years, at which point the business may often be put out for tender.  Although the large oil companies rarely switch providers, it does happen.  Our dilligence revealed that Innospec is currently undergoing a tender process with one of its large customers for about $20-30M of business (3-4% of overall revenue), which it could conceivably lose.  But outside of this one contract we have no reason to believe that other potentially large customer defections are potentially imminent.

3)      Pension - the company's pension is substantial in relation to it's market cap.  Every 3 years actuarial changes are made that could increase or decrease the liability.  Further increases in the liability could eat into operating profit and cashflow.